What should the Financial Stability and Development Council (FSDC) do?

Financial Express, 16 March 2010

Two kinds of reasons drive the need for better regulatory coordination in finance. The first is the Indian problem of having a large number of financial regulators. This requires coordination mechanisms to avoid difficulties and to get things done. The second is the problem of financial stability, which requires an institutionalised analytical and coordination mechanism. Better coordination is consistent with the twin goals of avoiding politicisation of monetary policy and of political interference in supervisory functions.

Coordination in systemic crises

The best case study of financial stability thinking in India was the liquidity crisis which mutual funds encountered in late 2008. This was a cross-cutting problem that involved RBI, SEBI, banks and mutual funds. The essence of understanding this financial stability problem, and resolving it, lay in pulling all four parties together and hammering out a solution.

This problem-solving was led by the then finance minister, Mr. Chidambaram. It required effort on his part in understanding an intricate problem, and pushing various agencies to come together with a reasonable solution. Now that the crisis is behind us, we need to ask ourselves: Can a better institutional mechanism be setup? When a comparable financial stability situation crops up in the future, can we rely more on the institutional structure and less on individuals?

The Ministry of Finance must play a lead role in this crisis-management component of regulatory coordination, because only MOF can authorise the use of taxpayer resources in putting together a rescue. This is not to advocate the wanton use of public money in solving difficulties in finance. But we must recognise that the occasional use of public resources (in a fully transparent manner) is a critical ingredient of the financial stability function, and only MOF can authorise fiscal actions.

Financial stability

Before a crisis has erupted, some group of civil servants needs to constantly scan the entire financial system and understand where the land mines are. This involves issues such as the problems of FMPs, the interest rate risk of Indian banks, the currency exposure of Indian corporations, etc. In each of these areas, India's `silo system' involves each regulator looking myopically at its own toes, and covering up for its own failures. The essence of financial stability thinking lies in having an analytical team which understands the frontiers of finance, looks at Indian finance as a whole, and is immune to the turf battles of the agencies.

Regulatory coordination

The FSDC must help defuse the regulatory conflicts, overlaps and blind spots of India's system of multiple regulators. A well known example is the fund management products which are sold both by SEBI-regulated mutual funds and by IRDA-regulated insurance companies. SEBI does more on consumer protection and soundness, so market share has shifted to insurance companies.

This is about conflicts and also about cross-cutting problems. Financial stability is clearly a cross-cutting problem, but there are many others. As an example, the top 20 financial conglomerates in India are doing business in all silos, but nobody in the government has a full picture of each of them: FSDC must develop a college of supervisors mechanism through which RBI/SEBI/etc. are able to know the full picture of (say) HDFC. For another example, India's long history of failure on the corporate bond market reflects the fact that the project requires actions by myriad agencies. The FSDC must play a role in project management here, coordinating a work plan that is spread across multiple regulators.

Regulatory independence

Does this involve treading on independence? The autonomy of regulators is a means, and not an end. Two kinds of independence are worth protecting. The first is the immunity of monetary policy from election compulsions. Central banks have been given independence, the world over, so that one narrow function (the setting of short term interest rates) is freed from election influence. The case for independence does not extend beyond this narrow function, which is why the role and function of independent central banks worldwide has been greatly curtailed.

The second class of issues where political interference is a problem is in individual transactions or investigations. As an example, we would not want the Ministry of Finance to interfere in RBI or SEBI's actions on the Bank of Rajasthan.

The FSDC should be constructed carefully so as to protect these two dimensions of independence. In everything else the normal processes of debate, policy reform and inter-agency coordination of a democracy must operate. Getting a debt market going requires pushing all government agencies to behave differently, which would be a good thing. When FMPs were in crisis, Mr. Chidambaram's impromptu FSDC asked RBI and SEBI to behave differently, which was a good thing. FSDC must bring greater pressure on agencies to behave differently in the interests of financial stability and development: or else it is not worth doing.